February 2, 2017

Using wealth, not returns, to set objectives and measure success

By Stefan Dunatov, Chief Investment Officer, Coal Pension Trustees Investment Limited

For asset owners that have liabilities to meet, whether they be pension or endowment funds, or a saver planning for retirement, one of the key questions they must answer is how much wealth they need to generate in order to at least meet those cash-flow requirements. Traditionally, investment objectives and our success in achieving those objectives has been predominantly measured by looking at total returns – the general level of return averaged across the life of the fund in question. For example, a pension fund would need to achieve X% return over its expected life to have sufficient assets to meet its expected liabilities. For an individual saver, what level of assets is enough to ensure they have sufficient funds to live on once they retire? It is becoming increasingly clear, however, that focussing on total returns is not sufficient. These questions may be better answered by looking in greater depth at the level of absolute wealth as a target consistent with a desired objective, and the impact of different paths of return on the likely level of that wealth during the accumulation and spending phases of a fund.

Wealth Matters 

Although pension funds, sovereign wealth funds, endowments and individual savers are all very different in nature, they all share a common feature: their level of wealth will determine how well they achieve their objective. While that level of wealth is dependent on investment returns, focussing too much on those returns may lead to objectives not being achieved. The path those returns take is also a key consideration.

Consider, for example, a sovereign wealth fund that wishes to grow its assets in line with inflation to keep its real spending power stable over the next 10 years in order to pay for an expected project in the future. For simplicity, let’s assume that this is a £1 billion fund with no expected inflows or outflows over the next decade and inflation will be 2% per annum over that period. The target wealth level is therefore £1.22 billion.

Now assume the fund is confident it can achieve a real 2% return over the 10-year term on average, but the pattern of those investment returns cannot actually be forecasted. There is a multitude of different paths those returns can take to achieve that real average return of 2%. Yet, those paths can result in very different outcomes for the fund.

For example, one path might be that returns are poor to begin with. On another returns are strong to be begin with. Although the average returns are the same across both scenarios, the total wealth they each generate is quite different because of the effects of compounding. A scenario where returns are poor to begin with will have less assets to grow once a period of strong returns arrives. The compounding effect is therefore less powerful than it would be for a fund that enjoys strong returns at the start of the period. See figure 1…

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